John Maynard Keynes, the great English economist, was highly critical of the stock market’s casino-like behavior in his time.
He likened investors to those who entered a newspaper competition to choose the six photographs out of a hundred that popular opinion thought to be the prettiest. Rather than devoting energy to figuring out which photos were indeed the prettiest, contestants spent their time guessing which photos the other contestants thought to be the prettiest.
Keynes thought that in the stock market, similarly, investors don’t bother to figure out what a company is really worth — rather, they try to guess what other people think it’s worth.
What would Keynes have made of today’s stock-market behavior? It is not simply that equity valuations have reached stratospheric levels. They also seem to be impervious to interest-rate developments and increased downside risks to the economic recovery.
One reason for suspecting irrational exuberance in today’s market is the historic heights equity valuations have reached. According to the Shiller Cyclical Adjusted Price Measure (CAPE), by the end of last year, US equity valuations were around double their long-run average. That was a level experienced only once before in the past 100 years.
It could be argued that last year’s historically high equity valuations were justified by rock-bottom interest rates on risk-free US government bonds. With the 10-year US Treasury rate below 1% for a protracted period, investors seemed to have no alternative but to take on more risk in the equity market if they expected to get a reasonable return on their investments. And any stream of expected future earnings is worth more if discounted at a low interest rate rather than a high interest rate.
But that leaves the question: Why do today’s equity prices seem essentially unmoved by the prospect of a higher interest-rate environment?
Federal Reserve Chair Jerome Powell recently signaled that the bank could soon be hiking interest rates in 50-basis point increments to deal with an inflation rate that has now reached a 40-year high. And the 10-year US Treasury rate has already more than doubled to its present level of 2.5%. And yet the stock market has barely budged.
Equally puzzling is the equity market’s seeming indifference to the rising downside risks to the recovery that could have clear implications for corporate earnings.
Russia’s Ukrainian invasion is sending oil, food and metal prices through the roof. China’s lockdown of major cities like Shanghai in response to a renewed COVID surge threatens to keep global supply chains disrupted and shipping costs high. As if that were not enough, the Fed is in the process of removing the punch bowl to deal with inflation by beginning an interest-rate-hiking cycle.
Interestingly, the bond market doesn’t share the stock market’s complacency about the economic outlook. For the first time since 2006, the five-year Treasury interest rate has risen above the corresponding 30-year interest rate. The stock market might want to note that in the past, this so-called inversion of the yield curve, where short-term rates exceed long-term rates, has been among the most reliable indicators of a recession on the horizon.
All this is not to say we should necessarily brace ourselves for an imminent large stock-market slump. After all, as Keynes himself remarked, markets can stay irrational for longer than you can stay solvent. Former Fed chief Alan Greenspan too saw a long lapse between his famous 1996 “irrational exuberance” observation and the eventual bear market.
But we should understand that having fueled stock-market speculation by years of ultra-easy monetary policy, the Fed has likely set us up for a hard stock-market landing down the road. That eventual correction could have important spillover effects to the rest of the economy — especially if it were to coincide with the bursting of the housing-market bubble.
As in the past, if households were to feel less wealthy and economically less secure, they would tighten their belts and cut back on their spending, which could send the economy into a nasty recession. All thanks to the Fed.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.